Cross-Border 2019: UCITS and Beyond

Firms that can align their product offering with new distribution trends, while understanding how to
capitalize on the benefits of upcoming regulation, will be positioned to succeed in 2019.

Asset managers faced strong regulatory headwinds over the past year as they adjusted to the Markets in Financial Instruments Directive 2’s stricter product governance requirements that forced many to reevaluate their distribution channels. In 2019 the regulatory winds are shifting and, along with changing investor preferences, may provide a tailwind by creating new product and distribution opportunities. With these opportunities come new challenges that may require new workflows and expertise. Whether considering the cross-border market for the first time or continuing to expand globally, keeping up with these developments is critical for asset managers.

Regulatory Tailwinds

The E.U. is set to finalize key regulatory changes that should improve the distribution of Undertakings for Collective Investments in Transferable Securities (UCITS) funds in Europe, as well as support the growing interest in Environmental, Social, and Governance (ESG) investing.

Improving UCITS Distribution in Europe
Distributed in over 80 countries, the E.U.’s UCITS fund framework is at the core of the cross-border industry. By the end of Q3 2018, UCITS funds’ total net assets reached €9.9 trillion, according to European Fund and Asset Management Association (EFAMA). For all of its success, a persistent problem with the UCITS framework is the prevalence of too many small funds. At the end of 2017, there were nearly 33,000 UCITS funds with an average size of $303 million, as opposed to the U.S., where there are fewer than 10,000 mutual funds with an average size of $2.3 billion, according to EFAMA. The proliferation of smaller funds means that UCITS often lack economies of scale, which can result in higher costs for the end investor. It can also discourage cross-border distribution because the costs fall disproportionally on smaller funds. According to the European Commission, only 37% of UCITS are sold in more than three E.U. member states.

The E.U. wants to increase the cross-border distribution of UCITS funds across Europe to try to help tackle the issue of sub-scale funds. As part of its Capital Market Union (CMU) project, the European Commission has proposed:

–Removing the ability of individual E.U. countries to impose physical presence requirements on managers marketing UCITS funds
–Harmonizing the rules to notify local regulators about share class changes
–Making it easier to discontinue marketing a fund

While the rules will not cause a revolution in European distribution, they could have a material impact on the industry. The Commission estimates that the proposed reforms may save the industry €440 million annually in European crossborder distribution costs.

Many U.S. managers often find the distribution nuances of local markets across the E.U. challenging. “U.S. asset managers are accustomed to a single market, currency and tax system,” warns Kelli O’Brien, Director, Custody and Fund Services at Citi. “Navigating through all of those differences in Europe is a really big challenge. As a result, managers frequently pursue a more limited distribution strategy in Europe.” Any move to create a more harmonized single market or remove the marketing physical presence requirements, should make distribution easier. This could help U.S. managers broaden their distribution strategy and attract more European investors.

Supporting ESG GrowthESG solutions continue to grow in popularity and Europe is leading the way. In 2017, Europe accounted for 53% of global sustainable investment assets, while the U.S. only accounted for 38%, according to Global Sustainable Investment Alliance. As Jervis Smith, Luxembourg Head of Prime, Futures, and Security Services at Citi, notes, “ESG is now going mainstream. We’re moving beyond retail investor interest and more institutional investors are considering non-financial elements when they make investment decisions.” This is pushing more asset managers to incorporate ESG considerations into their investment process. According to Christopher Christian, Financial Services Partner at Dechert, “Increasingly, we’re seeing the lack of ESG criteria being a reason that managers have been eliminated from the selection process.”

To help support the growth of ESG funds, the European Commission has proposed a new regulatory framework for asset management. The proposals include the creation of a standard ESG taxonomy and new low-carbon and positive-carbon impact benchmarks. Many in the industry think this will strengthen ESG products by making it easier for investors to compare and evaluate a fund’s ESG performance. It should also assist in shaking out funds that use the moniker as a marketing tool, which could help further boost investor confidence in the sector.

The E.U. is taking the lead on ESG regulation, which means, according to Sean Tuffy, Head of Market and Regulatory Intelligence, Custody and Fund Services at Citi, “It is very likely that the E.U. will create what’s going to become the global standard. Even asset managers who don’t have business in the E.U. should be tracking the potential implications of the E.U.’s ESG framework.”

Opportunities Beyond UCITS ProductsWhile UCITS are the foundation of a cross-border strategy, not all strategies work within the confines of the UCITS framework. Changing investor preference is affecting how cross-border funds are being developed and distributed. To meet this changing demand, firms are considering solutions beyond UCITS funds, which come with new challenges and product considerations.

The Challenges with Pivoting to Alternatives
As investors continue to search for yield and uncorrelated returns, interest in private equity, infrastructure, and real estate has become more significant in recent years. At the end of the Q3 2018, E.U. Alternative Investment Funds (AIFs) grew to a record €6.1 trillion, according to EFAMA. This has pushed traditional asset managers to consider more alternative assets classes and products. The shift to alternatives is not without challenges, especially if managers are trying to distribute their products broadly. Mike Tumilty, Director of Operations at Aberdeen Standard Investments cautions, “Every alternative fund brings nuances, special tax considerations, and suitability issues. This makes the underlying assets less conducive to being put into pooled vehicles that can be widely distributed.”

For example, the European Long-Term Investment Fund (ELTIF) is designed to give retail investors access to more illiquid investments. However, due to issues with the regulatory framework, ELTIF’s have not yet taken off. In the short term, while E.U. policymakers look to fine tune the ELTIF framework, managers looking into alternative funds will still have to use more bespoke fund structures.

A move into alternatives in Europe also brings with it another regulatory regime known as the Alternative Investment Fund Managers Directive (AIFMD). The AIFMD applies to all managers selling AIFs in the E.U., regardless of where the AIF or managers are domiciled. In addition to compliance and reporting requirements, the AIFMD also governs the distribution of AIFs in the E.U. and includes a pan-E.U. passport. However, the AIFMD passport is currently restricted to only E.U.-domiciled AIFs and non-E.U. AIFs must rely on private placement for distribution in the E.U.

Despite the challenges, the growth of alternatives is set to continue. PWC estimates that globally alternatives will grow at an average of 11% per year through 2020. To support this growth, asset managers need to invest in their platforms and find ways to make their processes more scalable. Asset managers looking to sell alternatives into the E.U. also need to understand how the AIFMD will affect their operations and distribution strategy. This includes determining if they can leverage their existing UCITS infrastructure or if they need to supplement with additional resources.

Cross-Border and Local Funds Combine for Global Distribution
While the use of UCITS funds for cross-border distribution has been successful, the truth is that a global distribution plan requires a mix of local and cross-border funds. Firms often establish a UCITS in Luxembourg or Ireland as their flagship cross-border product and then supplement that with local products where necessary. Angela Billick, Head of European Investment Product at Manulife John Hancock, notes, “Firms need to look at each market and find the best way to offer solutions to investors. While UCITS funds are an important piece of any firm’s cross-border strategy, a truly global approach requires having the right mix of global and local products.”

This strategy is particularly relevant for firms looking to enter Mainland China. Chinese policymakers have been unwilling to open the market to UCITS funds. This means that asset managers looking to access Mainland Chinese investors need to use local products. There are two main routes into the Mainland market for non-Chinese firms to consider.

The first option is to establish a Hong Kong fund and distribute it in Mainland China via the Mutual Recognition of Funds (MRF) program. The MRF program allows Mainland China and Hong Kong domiciled funds to be sold in either market. There are several restrictions to the MRF program, such as: local Hong Kong substance requirements and a quota system limits crossborder investors in MRF funds to no more than 50% of the fund’s total net assets. The quota restriction in particular has limited the success of the MRF program to date and has driven many asset managers to consider a local fund approach.

The local fund approach is to establish a Wholly Foreign-Owned Enterprise (WFOE) with a private fund management license in Mainland China. This allows managers to launch Mainland Chinese private funds that can be sold to domestic institutional investors. Establishing a WFOE requires a commitment of substance in Mainland China, as firms are currently limited to private funds and cannot access retail investors. However, starting in 2021 non-Chinese firms will be able to apply for a Fund Management Company license that enables the firm to offer services and products to the Mainland retail market.

The Way Forward

In order to take advantage of these opportunities, asset managers must be prepared to evolve their strategies to meet the new challenges. This includes having a holistic global vision on products and domiciles, and understanding how they can incorporate both UCITS and non-UCITS into their toolkits. Firms that can align their product offering with new distribution trends, while understanding how to capitalize on the benefits of upcoming regulation, will be positioned to succeed in 2019.